Outlook 2015: Indian equities

India’s Nifty index surged by close to 30% in 2014, yet despite this rally, market returns have been modest for the 2008-2014 period. The significance of the 2014 rally is that it has heralded the birth of a new bull market in India. The bull market came about because of three factors; cheap starting valuations, a turnaround in the economic cycle and a change in political leadership. The initial period of the bull market has seen the returns dominated by reratings of price-to-earnings ratios rather than earnings growth. We think that as this market matures in 2015, the contribution to returns should shift in favour of earnings growth.

As economic growth picks up, a meaningful demand revival is expected towards the end of 2015 and once this happens it will give a further large boost to earnings

Corporate profits to GDP

Source: JP Morgan, as of 31 March 2014

Corporate profits have trailed nominal GDP growth over the last few years. The pressure on profitability has come from a number of factors – a weak economy, large capex projects (many of which have got stuck or delayed), high interest rates and high input cost inflation. As most of these issues get sorted, we should be entering a period where earnings growth can outpace nominal GDP growth over the next few years.

The high number of capex projects that are under way should start paying off as delayed projects get back on track. The new government has sharply fast-tracked project approvals and is also untangling other roadblocks such as coal availability and fuel linkages for power plants. Furthermore, a number of leveraged companies are exiting projects that they do not have the capacity to finish. These projects are being acquired by companies and funds with plans to get them commissioned as soon as possible and this is being facilitated by banks that are under pressure from the Reserve Bank of India (RBI) on restructured loans and non-performing assets (NPAs). For example, a few companies in the power sector have announced initiatives to acquire troubled power plants with similar initiatives underway in other infrastructure sectors such as highways and ports. Buoyant equity markets will allow companies and private equity funds to raise capital to invest in such projects.

Input cost inflation for the manufacturing sector has been high in recent years on account of high global commodity prices and a weak currency. The sharp fall in commodity prices (especially crude oil) and the stability in the Indian rupee (on account of improved macro fundamentals) should bode well for bringing down input costs and improving margins. The fall in commodity prices is also helping bring down inflation in the economy. This fall in prices is creating the headroom for lower interest rates, which should bring down finance costs for companies.

The most significant driver for earnings growth over the medium term is operating leverage. Current low capacity utilisation levels will allow companies to take advantage of any demand revival through existing capacity, thus providing high marginal profitability of incremental demand. As economic growth picks up, a meaningful demand revival is expected towards the end of 2015 and once this happens it will give a further large boost to earnings.

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Capacity Utilisation (%)

Source: RBI, as of 30 June 2014

OECD Leading Economic Indicators – India

Source: OECD, as of 31 October 2014

Nifty Earnings growth Source: IIFL Research, as of 31 March 2014

Last year saw the return of the Indian investor to the equity market after many years and we expect the inflows to continue into 2015 as well. Equity ownership within Indian households remains abysmally low – both in absolute terms as well as compared to historical levels seen in 2007-08. As these holdings start to normalise, they can sustain large inflows into equities. Large domestic inflows are structurally important for the market for two reasons. Firstly, they can provide a counter-balance to foreign institutional investor flows and secondly, they also allow the absorption of the equity supply that will hit the market in 2015 as the bull market matures.

The market has gone through the entire year in 2014 without seeing a correction of over 10%. Historically, any bull market experiences corrections – the 2003-2007 market witnessed a number of 10% falls as well as some that were over 20%. So a correction can reasonably be expected to take place at some stage. The key lesson for investors is that they should not fret too much on the short-term ups and downs of the market and instead focus on the maturing bull market which still has a number of factors driving it in 2015.

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